The album covers downloaded by iTunes 7 are stored as .itc files, which are used to speed up the viewing of album covers. This is the original caching system that CoverFlow, which was purchased by Apple to create this new feature, used. These files can be found in folders in the user's Music -> iTunes -> Album Artwork folder. In there you'll see two folders, Download and Local. I suspect the Local folder is to cache locally-embedded artwork, to save iTunes reading each file every time for the CoverFlow view.
The important thing to note is that artwork downloaded using iTunes 7 is only stored here and is not embedded into the Music file. If you want to have the artwork embedded, then you have to paste it into the Artwork box in the song's Info window. One way to do this (idea partly from Scott's blog) is to use the download option for an album and then view a single song's Info window. Next, go to the Artwork tab and select and copy the artwork. Now go back and select all the songs and view the Info window for all of them at once. Paste the artwork into the Artwork box, and you're done. Note: You do not need to clear downloaded artwork to do this.
A second hint is if you want to look at the .itc files created by iTunes, you can open them with GraphicConverter.
Mac OS X Hints
http://hints.macworld.com/article.php?story=20060915043555719